**U. S. SECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549**

**FORM 10-Q**

   

(X)        QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF SECURITIES EXCHANGE ACT OF1934

For the quarterly period ended March 31, 2004

(  )         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

For the transition period from __________ to__________

Commission file number  0-26016

**PALMETTO BANCSHARES, INC.**(Exact name of registrant as specified inits charter)

| **South Carolina**
**74-2235055**
**(State or other jurisdiction of incorporation      or organization)**
**(IRS Employer Identification No.)**
**301 Hillcrest Drive, Laurens, South Carolina**
**29360**
**(Address of principal executive offices)**
**(Zip Code)**
**(864) 984-4551**
**palmettobank.com**
**(Registrant's telephone number)**
**(Registrant's web site)**
Indicate by check mark whetherthe registrant (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past 90 days. Yes X  No __  

Indicate by check mark whetherthe registrant is an accelerated filer (as defined in Rule 12b-2 of the ExchangeAct).  Yes X   No __ 

Indicate the number of sharesoutstanding of each of the issuer's classes of common stock, as of the latestpracticable date.
Class
Outstanding at May 3, 2004       -----------------------------
-------------------------------
Common stock, $5.00 par value
 6,265,490 
**PALMETTO      BANCSHARES, INC.**
**Table of      Contents**
Page No.
**PART I.  FINANCIAL INFORMATION**
3
Item 1.
Financial Statements
3
Item 2.
Management's Discussion and Analysis of Financial      Condition and  Results of Operations
13
Item 3.
Quantitative and Qualitative Disclosures about Market      Risk
35
Item 4.
Controls and Procedures
37  
**PART II.  OTHER INFORMATION**
38
Item 1.
Legal Proceedings
38
Item 2. 
Changes in Securities and Use of Proceeds
38
Item 3.
Defaults Upon Senior Securities
38
Item 4.
Submission of Matters to a Vote of Security Holders
38
Item 5.
Other Information
38
Item 6.
Exhibits and Reports on Form 8-K
38 
**SIGNATURES**
39
 

 

 

 

 

 

2
**PART I.  FINANCIAL INFORMATIONITEM  I.  FINANCIAL STATEMENTS**
 

**PALMETTO BANCSHARES, INC.**
**Consolidated Balance Sheets**
**(in thousands, except share data)**
** **
**March 31,**
**December 31,**
**2004**
** **
**2003**
**2003**
(unaudited)
** **
ASSETS
Cash and due from banks
 $  26,406 
 32,953 
 32,309 
Federal funds sold
 10,090 
 14,479 
 930 
Cash and cash equivalents
 36,496 
 47,432 
 33,239 
Federal Home Loan Bank (FHLB)      stock, at cost
   2,122 
1,868 
1,868 
Investment securities      available for sale at fair value
 106,373 
113,138 
128,930 
Loans held for sale      
6,353 
11,093 
6,399 
Loans 
706,999 
646,628 
693,213 
Less allowance for loan      losses
(7,692)
 (6,771)
(7,463)
Loans, net
699,307 
 639,857 
 685,750 
Premises and equipment,      net
21,927 
19,805 
21,724 
Accrued interest      receivable
 3,784 
 4,114 
4,083 
Other assets
   17,331 
 15,792 
16,086 
Total assets
 $ 893,693 
   853,099 
 898,079 
LIABILITIES AND      SHAREHOLDERS' EQUITY
Liabilities
Deposits
Noninterest-bearing
 $122,247 
              116,615 
 115,982 
Interest-bearing
 656,554 
              622,144 
655,766 
Total deposits
778,801 
738,759 
771,748 
Securities sold under      agreements to repurchase
 18,126 
                16,261 
13,525 
Commercial paper (Master      notes)
 16,339 
                16,965 
16,170 
Federal funds purchased
 -   
                         -
 18,000 
Other liabilities
 5,772 
                11,358 
6,647 
Total liabilities
 819,038 
              783,343 
826,090 
Shareholders' equity
Common stock - par value      $5.00 per share;  authorized        10,000,000 shares; issued and      outstanding 6,265,440,        6,329,909 and 6,263,210 at March 31, 2004 and      2003         and December 31, 2003, respectively.
 31,327 
                31,650 
31,316 
Capital surplus
 268 
 89 
 250 
Retained earnings
 41,607 
          36,314 
39,454 
Accumulated other      comprehensive income, net of tax
 1,453 
                  1,703 
969 
Total shareholders'      equity
74,655 
                69,756 
71,989 
Total liabilities and      shareholders' equity
 $ 893,693 
              853,099 
 898,079 
See accompanying notes to consolidated interim financial statements.

3

**PALMETTO BANCSHARES, INC. **

**Consolidated Statements of Income**

**(in thousands, except share data) **

**For the three months ended March 31,**

**2004**

** **

**2003**

(unaudited)

Interest income

Interest and fees on loans

 $      11,271 

          11,543 

Interest and dividends on investment securities available for sale

U.S. Treasury and U.S. Government agencies

               108 

               415 

State and municipal

               510 

               382 

Mortgage-backed securities

               338 

               209 

Interest on federal funds sold

                 15 

                 35 

Dividends on FHLB stock

                 19 

                 23 

Total interest income

         12,261 

          12,607 

Interest expense

Interest on deposits, including retail repurchase agreements

            2,480 

            2,804 

Interest on other borrowings

                 19 

                    4 

Interest on commercial paper (Master notes)

                 23 

                 23 

Total interest expense

            2,522 

            2,831 

Net interest income

            9,739 

            9,776 

Provision for loan losses

               750 

               900 

Net interest income after provision for loan losses

            8,989 

            8,876 

Noninterest income

Service charges on deposit accounts

            2,083 

            2,004 

Net fees for trust and brokerage services

               670 

               598 

Mortgage banking income

               165 

               100 

Investment securities gains

               108 

                 95 

Other 

               696 

               637 

Total noninterest income

            3,722 

            3,434 

Noninterest expense

Salaries and other personnel 

            4,636 

            4,491 

Occupancy

               591 

               567 

Furniture and equipment

               883 

               813 

Postage and supplies

               321 

               396 

Marketing and advertising

               214 

               184 

Telephone

               182 

               184 

Professional services

               186 

               157 

Other 

            1,233 

            1,218 

Total noninterest expense

            8,246 

8,010 

Income before income taxes

            4,465 

            4,300 

Provision for income taxes

            1,435 

            1,398 

Net income

 $        3,030 

            2,902 

Share Data:

Net income - basic

 $           0.48 

              0.46 

Net income - diluted

              0.48 

              0.45 

Book value

            11.92 

            11.02 

Weighted average common shares outstanding - basic

    6,264,069 

    6,326,698 

Weighted average common shares outstanding - diluted

    6,365,180 

    6,482,699 

See accompanying notes to consolidated interim financial statements.

4

**PALMETTO BANCSHARES, INC. **

** Consolidated Statements of Changes in Shareholders' Equity and Comprehensive Income **

**(in thousands, except share data) (unaudited)**

Accumulated

Shares of

other

common

Common

Capital

Retained

comprehensive

stock

stock

surplus

earnings

income, net

Total

Balance at December 31, 2002

 6,324,659 

 $   31,623 

                50 

         34,173 

                        1,675 

         67,521 

Net income

            2,902 

            2,902 

Other comprehensive income, net of tax:

     Net unrealized holding gains (losses) arising during period, net

          of tax effect of $54

                              86 

     Less:  reclassification adjustment for gains included

          in net income, net of tax effect of $37

                           (58)

     Net unrealized gains  on securities

                 28 

Comprehensive income

            2,930 

Cash dividend declared and paid ($0.12 per share)

             (761)

             (761)

Stock option activity

         5,250 

27 

                39 

                 66 

Balance at March 31, 2003

 6,329,909 

 $   31,650 

               89 

         36,314 

                        1,703 

         69,756 

Balance at December 31, 2003

 6,263,210 

 $   31,316 

              250 

         39,454 

                           969 

         71,989 

Net income

            3,030 

            3,030 

Other comprehensive income, net of tax:

     Net unrealized holding gains (losses) arising during period, net

          of tax effect of $344

                           550 

     Less:  reclassification adjustment for gains included

          in net income, net of tax effect of $42

                            (66)

     Net unrealized gains on securities

               484 

Comprehensive income

            3,514 

Cash dividend declared and paid ($0.14 per share)

             (877)

             (877)

Stock option activity

         2,230 

              11 

                18 

                 29 

Balance at March 31, 2004

 6,265,440 

 $   31,327 

              268 

         41,607 

                        1,453 

         74,655 

See accompanying notes to consolidated interim financial statements.

5

**PALMETTO BANCSHARES, INC. **

**Consolidated Statements of Cash Flows **

**(in thousands) **

**For the three months ended March 31,**

**2004**

** **

**2003**

(unaudited)

Cash flows from operating activities

Net income

 $       3,030 

          2,902 

Adjustments to reconcile net income to net cash 

provided by (used in) operating activities

Depreciation and amortization

          1,031 

             249 

Gain on sale of investment securities

            (108)

              (95)

Provision for loan losses

             750 

             900 

Origination of loans held for sale

      (13,545)

      (36,773)

Proceeds from sale of loans held for sale

        13,756 

37,870 

Gain on sale of loans

            (165)

(339)

Change in accrued interest receivable

299 

32 

Change in other assets

(394)

(21)

Change in other liabilities, net

(1,177)

3,531 

Net cash provided by operating activities

3,477 

8,256 

Cash flows from investing activities

Purchase of investment securities available for sale

         (3,035)

      (15,327)

Proceeds from maturities of investment securities available for sale

          5,838 

          4,335 

Proceeds from sale and calls of investment securities available for sale

        15,335 

          9,114 

Principal paydowns on mortgage-backed securities available for sale

          5,031 

          3,744 

Purchase of Federal Home Loan Bank stock

            (254)

            (135)

Net increase in loans outstanding

      (15,433)

      (21,750)

Purchases of premises and equipment, net

            (677)

            (527)

Net cash provided by (used in) investing activities

          6,805 

      (20,546)

Cash flows from financing activities

Net increase in deposit accounts

7,053 

        16,768 

Net increase in securities sold under agreements to repurchase

4,601 

          3,430 

Net increase in commercial paper

169 

          2,126 

Net decrease in federal funds purchased

      (18,000)

                 -   

Proceeds from stock option activity

                29 

                66 

Dividends paid

            (877)

            (761)

Net cash provided by (used in) financing activities

(7,025)

        21,629 

Net increase in cash and cash equivalents

3,257 

9,339 

Cash and cash equivalents at beginning of quarter

33,239 

        38,093 

Cash and cash equivalents at end of quarter

 $     36,496 

        47,432 

Supplemental Information

Cash paid during the period for:

Interest expense

 $       2,603 

          2,926 

Income taxes

692 

             962 

Supplemental schedule of non-cash investing and financing transactions

Change in unrealized gain on investment securities available 

for sale, pre-tax

 $          786 

                45 

Loans transferred to other real estate owned

1,126 

             133 

Loans charged -off

569 

             588 

See accompanying notes to consolidated interim financial statements.

6

**PALMETTO BANCSHARES, INC.****Notes To Consolidated FinancialStatements**

1.  GENERAL

Nature of OperationsPalmetto Bancshares ("Bancshares") isa bank holding company headquartered in Laurens, South Carolina and organizedin 1982 under the laws of South Carolina. Through its wholly-owned subsidiary,The Palmetto Bank (the "Bank"), and the Bank's wholly-owned subsidiary,Palmetto Capital, Inc. ("Palmetto Capital"), (collectively Palmetto Bancshares,Inc. or the "Company"), the Company engages in the general banking businessthrough 30 retail branch offices in the Upstate South Carolina markets ofLaurens, Greenville, Spartanburg, Greenwood, Anderson, Cherokee, Abbeville, andOconee counties (the "Upstate"). The Bank was organized and chartered underSouth Carolina law in 1906.  

The industryin which the Bank operates exists primarily to provide an intermediary serviceto the general public with funds to deposit and, by using these funds, tooriginate loans in the markets served. The Bank provides a full range ofbanking activities, including such services as checking, savings, money market,and other time deposits for a wide range of consumer and commercial depositors;loans for business, real estate, and personal uses; safe deposit box rental;various electronic funds transfer services; telephone banking; and bank cardservices. The Bank's indirect lending department establishes relationships withUpstate automobile dealers to provide customer financing on qualifyingautomobile purchases, and the Bank's mortgage banking operation meets a rangeof its customers' financial service needs by originating, selling, andservicing mortgage loans. The Bank also offers both individual and commercialtrust services through an active trust department. Palmetto Capital, the brokeragesubsidiary of the Bank, offers customers stocks, treasury and municipal bonds,mutual funds, and insurance annuities, as well as college and retirementplanning. The Company'sprimary market area is the Upstate of South Carolina. 

Principles of Consolidation and Basis of PresentationTheaccompanying consolidated financial statements include the accounts of PalmettoBancshares, Inc.  Inmanagement's opinion, all significant intercompany accounts and transactionshave been eliminated, and all adjustments necessary for a fair presentation ofthe results for interim periods presented have been included.  Any suchadjustments are of a normal and recurring nature.  The Companyoperates as one business segment, banking, which includes other financial services.Assets held by the Company, the Bank, or Palmetto Capital in a fiduciary oragency capacity for customers are not included in the consolidated financialstatements as such items do not represent assets of the Company, the Bank, orPalmetto Capital.

The consolidated financial statements presented herein are prepared inaccordance with the instructions for Form 10-Q.  Accordingly, certaininformation and footnotes required by generally accepted accounting principlesfor complete financial statements are not included.  The statements should beread in conjunction with the financial statements and footnotes theretoincluded in Palmetto Bancshares, Inc.'s Annual Report on Form 10-K for the yearended December 31, 2003.

ReclassificationsCertain amounts previously presented in the consolidatedfinancial statements forprior periods have been reclassified to conform to current classifications. Allsuch reclassifications had no effect on the prior years' net income orshareholders' equity as previously reported.

AccountingEstimates and AssumptionsThe accounting and reporting policies of the Company conformto accounting principles generally accepted in the United States of America andto general practices within the banking industry. In preparing its consolidatedfinancial statements,management is required to make estimates and assumptions that affect thereported amounts of assets and liabilities and the disclosure of contingentassets and liabilities as of the dates of the consolidated balance sheets forthe periods presented. In addition, they affect the reporting amounts of incomeand expense during the reporting period as of the dates of the consolidatedstatements of income for the periods presented. Actual results could differfrom these estimates and assumptions.  As such, the results of operations forthe three months ended March 31, 2004 are not necessarily indicative of theresults of operations that may be expected in future periods.

7

Website Availability of Reports Filed with the Securitiesand Exchange CommissionThe Company's website, www.palmettobank.com, includes a linkto the Securities and Exchange Commission's Electronic Data Gathering,Analysis, and Retrieval ("EDGAR") system which makes various reports filed withthe Securities and Exchange Commission, including its Annual Report on Form10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, OwnershipReports filed in conjunction with Section 16, and amendments to such reports,available, free of charge.  These reports are made available as soon asreasonably practicable after these reports are filed with, or furnished to, theSecurities and Exchange Commission.  The Securities and Exchange Commission'sEDGAR database may also be accessed through its website, www.sec.gov.

Summary of Significant Accounting PoliciesThe significant accounting policies used by the Company forreporting within this quarterly report are consistent with the accountingpolicies followed for annual financial reporting as described in Note 1 ofNotes to Consolidated Financial Statements included in the Company's AnnualReport on Form 10-K for the year ended December 31, 2003. 

2.   MORTGAGESERVICING RIGHTS

The Bank makesboth fixed rate and adjustable rate mortgage loans with terms generally rangingfrom 10 to 30 years and generally retains servicing on loans originated. Realestate lending is generally considered to be collateral-based lending with loanamounts based on predetermined loan to collateral values, and liquidation ofthe underlying real estate collateral is viewed as the primary source ofrepayment in the event of borrower default.

Effective inthe third quarter 2003, the Company began utilizing the expertise of a thirdparty to determine the value of mortgage-servicing rights ("MSRs") as well asthe related amortization and impairment of such rights. The external valuationutilizes estimates for the amount and timing of mortgage loan repayments,estimated prepayment rates, credit loss experience, costs to service loans, anddiscount rates to determine an estimate of the fair value of the Company'smortgage-servicing rights asset. Management believes that the modelingtechniques and assumptions used in conjunction with the valuation arereasonable.

In accordancewith Statement of Financial Accounting Standards ("SFAS") No. 140, the thirdparty evaluator stratified mortgage-servicing assets based on predominant riskfactors in order to evaluate impairment. Management noted that assets arestratified by interest rates and investor. The Company recognizes impairment asreported by the third party evaluator through a valuation allowance. Impairmentreported by the third party evaluator is the difference between the period endbook value and the market value at the same time.

Grossmortgage-servicing rights totaled approximately $2.5 million and $2.1 millionat March 31, 2004 and 2003, respectively, and are included in other assets onthe consolidated balance sheets. A valuation allowance of $90 thousand and $159thousand existed at March 31, 2004 and 2003, respectively. Grossmortgage-servicing rights totaled approximately $2.6 million at December 31,2003.  At the same time, a valuation allowance of $40 thousand was required.

8

Amortization expense is based oncurrent information regarding loan payments and prepayments. Amortizationexpense could change in future periods based on changes in the volume ofprepayments and other environmental factors. Prepayments could increase as aresult of any further decline in market interest rates, leading to an increasein amortization expense. Amortization expense for MSRs was booked totaling $189thousand and $420 thousand for the three months ended March 31, 2004 and 2003,respectively.  Amortization expense for MSRs for the twelve months endedDecember 31, 2003 totaled $1.1 million. 

The table setforth below summarizes the changes in mortgage-servicing rights, net ofvaluation allowance, for the quarters ended March 31 (in thousands). 

** **

** **

 

For the  quarters ended March 31,

** **

 

2004

2003

Mortgage-servicing rights, net of  valuation    allowance, beginning of period

$   2,566

1,957

Capitalized mortgage-servicing  rights

150

478

Amortization

(189)

(420)

Change in valuation allowance  

(50)

(46)

Total mortgage-servicing rights, net  of valuation allowance, end of period

$   2,477

1,969

The table setforth below summarizes the activity impacting the valuation allowance forimpairment of mortgage-servicing rights for the quarters ended March 31 (inthousands).

** **

 

For the  quarters ended March 31,

** **

 

2004

2003

Valuation allowance, beginning of  period

$   40

113

Aggregate additions charged and  reductions    credited to operations

50

46

Valuation allowance, end of period

$   90

159

3.    INTANGIBLE ASSETS

The Company's intangible assets withinfinite lives are included in other assets on the consolidated balancesheets.  These assets totaled $3.7 million at March 31, 2004, December 31,2003, and March 31, 2003.

The Companytests for impairment in accordance with SFAS No. 142. Potential impairment ofgoodwill exists when the carrying amount of a reporting unit exceeds itsimplied fair value. To the extent a reporting unit's carrying amount exceedsits fair value, an indication exists that the reporting unit's goodwill may beimpaired and the reporting unit's goodwill is estimated by allocating thereporting unit's fair value to all of its assets (recognized and unrecognized)and liabilities as if the reporting unit had been acquired in a businesscombination at the date of the impairment test. If the implied fair value ofthe reporting unit's goodwill is lower that its carrying amount, goodwill isimpaired and is written down to the implied fair value. The loss recognized islimited to the carrying amount of goodwill. Once an impairment loss isrecognized, future increases in fair value will not result in the reversal ofpreviously recognized losses. Based on the Company's impairment analysisperformed during 2003, the carrying amount of reporting units does not exceedimplied fair value. Therefore, no impairment loss was recorded during thetwelve-month period ended December 31, 2003.  The Company will retest intangible assets with infinitelives for impairment during the second quarter of 2004 to determine whether ornot an impairment loss is required to be booked in accordance with SFAS No.142.

 

9

The table set forth below illustrates the activity ofintangible assets with finite lives, which are comprised of customer listintangibles, included in other assets on the consolidated balance sheets, and the related amortization,included in other noninterest expense on the consolidated statements of income,for the quarters ended March 31 (in thousands).

** **

   

For the  quarters ended March 31,

** **

   

2004

2003

Balance, beginning of period

$   464

608

Amortization

36

34

Balance, end of period

$   428

574

Amortization of intangible assets with finite lives totaled$144 thousand for the year ended December 31, 2003.

The Company expects to record amortization expense relatedto intangibles of $144 thousand for fiscal years 2004 and 2005, $48 thousandfor fiscal years 2006 and 2007, $45 thousand for fiscal year 2008, and $33thousand for fiscal year 2009.

4.   NET INCOME PER COMMON SHARE

Basic and diluted earnings per share have been computedbased on net income presented in the accompanying consolidated statements ofincome divided by the weighted average common shares outstanding or assumed tobe outstanding as summarized below:

    
 
For the quarters ended March31,
   2004 2003                BASIC                   Averagecommon shares outstanding (denominator)    6,264,069         6,326,698                                DILUTED                   Averagecommon shares outstanding 6,264,069 6,326,698                Dilutivepotential common shares    101,111  156,001                Averagediluted shares outstanding (denominator)  6,365,180         6,482,699
Option shares are excluded from the calculation of dilutedearnings when the exercise price is greater than the average market price ofthe common shares.  At March 31, 2004, there were no option shares that wereexcluded from the calculation of diluted earnings due to the exercise pricebeing greater than the average market price of the common shares as of thatdate, based on information available to the Company at that time.

5.   EMPLOYEE BENEFITPLANS

Postretirement BenefitsThe Bank has anoncontributory defined benefit pension plan that covers all full-timeemployees who have at least twelve-months continuous service and have attainedage 21. The plan is designed to produce a designated retirement benefit, andbenefits are fully vested at five or more years of service. No vesting occursuntil five years of service has been achieved. The Bank's Trust Departmentadministers the plan. Contributions to the plan are made as required by theEmployee Retirement Income Security Act of 1974.

10

The followinginformation has been prepared to present the components of net period benefit cost for thequarters ended March 31 (in thousands). 

** **

 

For the  quarters ended March 31,

** **

 

2004

2003

Service cost

$     148

136

Interest cost

163

152

Expected return on plan assets

(214)

(200)

Amortization of prior service cost

2

2

Amortization of the  net loss

20

29

Net periodic benefit cost

$    119

119

The Companypreviously disclosed in its Annual Report on Form 10-K for the year endedDecember 31, 2003, that it expected to contribute $1.3 million to itsnoncontributory defined benefit pension plan during 2004. During the quarterended March 31, 2004, $335 thousand was contributed. 

Stock Option PlanAt March 31, 2004, the Company had astock-based employee and director option plan, which are described more fullyin Note 12 of Notes to Consolidated Financial Statements included in theCompany's Annual Report on Form 10-K for the year ended December 31, 2003.  SFAS No. 123,"Accounting for Stock-Based Compensation," allows a company to either adopt thefair value method of valuation or continue using the intrinsic valuation methodpresented under Accounting Principles Bulletin ("APB") Opinion 25, "Accountingfor Stock Issued to Employees," to account for stock-based compensation. TheCompany has elected to continue following APB Opinion 25 and provide pro formanet income and pro forma earnings per share disclosures for employee stockoption grants as if the fair value-based method defined in SFAS No. 123 hadbeen applied. As such, no stock-based employee compensation cost has beenreflected in net income, as all stock options granted under these plans had anexercise price equal to the fair market value of the underlying common stock onthe date of grant.

In December2002, the Financial Accounting Standards Board ("FASB") issued SFAS No. 148,"Accounting for Stock-Based Compensation - Transition and Disclosure - anamendment of FASB Statement No. 123." This Statement amends SFAS No. 123 toprovide alternative methods of transition for a voluntary change to the fairvalue-based method of accounting for stock-based employee compensation. Inaddition, this Statement amends the disclosure requirements of SFAS No. 123 torequire prominent disclosures in both annual and interim financial statementsabout the method of accounting for stock-based employee compensation and theeffect of the method used on reported results. The transition and disclosureprovisions were required for financial statements for fiscal periods endingafter December 15, 2002. The Company adopted this standard effective December31, 2002 and has included the required interim disclosures herein. 

The table set forth below illustrates the impact on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based compensation for the quarters ended March 31 (in thousands, except share data).

 
 For the quarters ended March 31,  2004 2003 Net income, as reported3,030 2,902 Deduct: Total stock-based employee and director    
       compensation expense determined under    
     fair value-based methods for all awards,    
     net of related tax effects33 27 Pro forma net income2,997 2,875      Earnings per share         Basic – as reported.48 .46      Basic – pro forma.48 .45           Diluted – as reported.48 .45      Diluted – pro forma .47 .44       
                                              

11

The fair value of each optiongranted is estimated on the date of grant using the Black-Scholesoption-pricing model with the following weighted-average assumptions used forgrants during 2004 and 2003, respectively: dividend yield of 2.7% and 2.6%,expected volatility of 18% for grants during both years, average risk-freeinterest rate of 4% for grants during both years, expected lives of 10 years,and a vesting period of five years. The weighted average fair value of optionsgranted approximated $4.58 in 2004 and $4.38 in 2003. For purposes of the proforma calculation, compensation expense is recognized on a straight line basisover the vesting period.

In November 2003, the FASB issued atentative decision related to fair value accounting of stock options requiringthat all unvested options begin being expensed in companies' 2005 financialstatements, which included guidance on how equity-based awards will be valued,expensed, and classified. The Company anticipates that the adoption of suchdecisions will have an impact on the Company's financial position or results ofoperations although such impact cannot be determined at this time.

                                     
 
 

 

12

**Item 2. Management's Discussion and Analysis of Financial Condition and Results ofOperations**

Thefollowing discussion and analysis is presented to assist in understanding thefinancial condition and results of operations of Palmetto Bancshares, Inc. This discussion should be read in conjunction with the consolidated financialstatements and related notes and other financial data appearing in this reportas well as in the Company's Annual Report on Form 10-K for the year endedDecember 31, 2003.  Results of operations for the three months ended March 31, 2004are not necessarily indicative of results that may be attained for any otherperiod.  Percentage calculations contained herein have been calculated basedupon actual, not rounded, results.

COMPANY OVERVIEW

Palmetto Bancshares ("Bancshares") is a bank holding companyheadquartered in Laurens, South Carolina and organized in 1982 under the lawsof South Carolina. Through its wholly-owned subsidiary, The Palmetto Bank (the"Bank"), and the Bank's wholly-owned subsidiary, Palmetto Capital, Inc. ("PalmettoCapital"), (collectively Palmetto Bancshares, Inc. or the "Company"), theCompany engages in the general banking business through 30 retail branchoffices in the Upstate South Carolina markets of Laurens, Greenville,Spartanburg, Greenwood, Anderson, Cherokee, Abbeville, and Oconee counties (the"Upstate"). The Bank was organized and chartered under South Carolina law in1906.  

The industry in which the Bankoperates exists primarily to provide an intermediary service to the generalpublic with funds to deposit and, by using these funds, to originate loans inthe markets served. The Bank provides a full range of banking activities,including such services as checking, savings, money market, and other timedeposits for a wide range of consumer and commercial depositors; loans forbusiness, real estate, and personal uses; safe deposit box rental; variouselectronic funds transfer services; telephone banking; and bank card services.The Bank's indirect lending department establishes relationships with Upstateautomobile dealers to provide customer financing on qualifying automobilepurchases, and the Bank's mortgage banking operation meets a range of itscustomers' financial service needs by originating, selling, and servicingmortgage loans. The Bank also offers both individual and commercial trustservices through an active trust department. Palmetto Capital, the brokeragesubsidiary of the Bank, offers customers stocks, treasury and municipal bonds,mutual funds, and insurance annuities, as well as college and retirementplanning. The Company'sprimary market area is the Upstate of South Carolina. 

FORWARD-LOOKINGSTATEMENTS

The Company makes forward-lookingstatements (as definedin the Private Securities Litigation Reform Act of 1995) in this reportand in other reports and proxy statements filed with the Securities andExchange Commission (the "SEC"). In addition, the Company's management may makeforward-looking statements orally. Broadly speaking, forward-looking statementsinclude, but are not limited to, projections of the Company's revenues, income,earnings per share, capital expenditures, dividends, capital structure, orother financial items, descriptions of plans or objectives of the Company forfuture operations, products or services, forecasts of the Company's futureeconomic performance, and descriptions of assumptions underlying or relating toany of the foregoing. 

Forward-looking statements discussmatters that are not historical facts. Because they discuss future events orconditions, forward-looking statements often include words such as"anticipate," "believe," "estimate," "expect," "intend," "plan," "project,""target," "can," "could," "may," "should," "will," "would," or similarexpressions. Do not unduly rely on forward-looking statements. Such statementsgive management's expectations about the Company's future and are notguarantees. Forward-looking statements speak only as of the date they are made,and the Companyundertakes no obligation to update any forward-looking statement to reflectevents or circumstances after the date on which such statement is made toreflect the occurrence of unanticipated events. In addition, certain statementsincluded in future filings of the Company with the SEC, in press releases, and/ or in oral and written statements made by or with the approval of theCompany, which are not statements of historical fact, constituteforward-looking statements.

 

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There are several factors, many beyondthe Company's control, that could cause results to differ from expectations.Some of these factors include, but are not limited to,
- changes in economic and / or     industry conditions and monetary policy;
- changes in interest rates,     deposit rates, the net interest margin, and / or funding sources;
- market risk and inflation;
- risks inherent in making loans     including repayment and collateral risk;
- volume of loan growth;
- the adequacy of the allowance for     loan losses (the "Allowance") and the assessment of problem loans;
- the ability of the Company to     meet its contractual obligations;
- fluctuations in consumer     spending;
- competition in the banking     industry and the related demand for the Company's products and services;
- dependence on senior management;
- technological changes;
- the ability to increase market     share;  
- the reliability of expense     projections;
- risks associated with income     taxes, including the potential for adverse adjustments;
- changes in accounting policies     and practices;
- potential cost and impact of     litigation; and
- the impact of recently-enacted or proposed legislation.

Many of these factors, as well asother factors, such as credit, market, operational, liquidity, interest rate,and other risks, are discussed in more detail in the Company's Annual Report onForm 10-K for the year ended December 31, 2003. Any factor described in thisQuarterly Report on Form 10-Q or in the Company's Annual Report on Form 10-Kcould by itself, or together with one or more factors, adversely affect theCompany's business, financial condition, and / or results of operations.Additionally, there are factors that may not be described in this report thatcould also cause actual results to differ from expectations.

CRITICAL ACCOUNTING POLICIES

The Company's accounting and financialreporting policies are in conformity with generally accepted accountingprinciples. The preparation of financial statements in conformity with suchprinciples requires management to make estimates and assumptions that impactthe reported amounts of assets and liabilities, the disclosure of contingentassets and liabilities at the date of the financial statements, and thereported amounts of revenues and expenses during the reporting period. Duringthe annual financial reporting process, management, in conjunction with theCompany's independent auditors, discusses the development and selection of thecritical accounting estimates with the Audit Committee of the Company's Boardof Directors.  Additionally, the Audit Committee reviews the Company's relateddisclosures.

The Company's significant accountingpolicies are discussed in Item 7 and Note 1 of Notes to Consolidated FinancialStatements of the Company's Annual Report on Form 10-K for the year endedDecember 31, 2003. Of these significant accounting policies, the Companyconsiders its policies regarding the accounting for its allowance for loanlosses, pension plan, mortgage-servicing rights, and income taxes, to be itsmost critical accounting policies due to the valuation techniques used and thesensitivity of these financial statement amounts to the methods, assumptions,and estimates underlying these balances. Accounting for these critical areasrequires a significant degree of management judgment that could be subject torevision as current information becomes available. In order to assist in thedetermination of critical accounting policies, management considers whether theaccounting estimate requires assumptions about matters that were highlyuncertain at the time the accounting estimate was made and whether differentestimates that reasonably could have been used in the current period, orchanges in the accounting estimate that are reasonably likely to occur fromperiod to period, would have a material impact on the Company's financialcondition or results of operations.

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Based on a critical assessment of itsaccounting policies and the underlying judgments and uncertainties impactingthe application of these policies, management believes that the Company'sconsolidated financial statements provide a meaningful and fair perspective ofthe Company. This is not to suggest that other general risk factors, some ofwhich are described in Forward-Looking Statements, could not adversely impactthe Company's financial position and results of operations.

FIRST QUARTER HIGHLIGHTS

At March 31, 2004, the Company'sassets totaled $893.7 million, a decrease of $4.4 million or 0.5% from December31, 2003. Contributing to the decrease in total assets at March 31, 2004compared with December 31, 2003 was an increase in total loans of $13.7 millionmore than offset by a decline in the investment securities available for saleportfolio, which declined $22.6 million over the same periods. Totalliabilities decreased $7.1 million, or 0.9%, at March 31, 2004 over December31, 2003, to a balance of $819.0 million. This decrease resulted from anincrease in traditional deposits of $7.1 million, or 0.9%, which was more thanoffset by a decline in the Company's federal funds purchased position, whichdeclined $18.0 million to a balance of zero over the same periods. Totaldeposits and other borrowings were $813.3 million at March 31, 2004 down from$819.4 million at December 31, 2003. Total shareholders' equity at March 31,2004 totaled $74.7 million, an increase of $2.7 million, or 3.7%, over December31, 2003.

Net income for the quarter ended March 31, 2004 increased4.4% to $3.0 million from $2.9 million in the comparable quarter of 2003. Basicearnings per common share increased 4.3% to $0.48 per common share for thecurrent quarter compared to the March 2003 quarter. On a diluted basis, earningsper common share increased to $0.48 from $0.45 in the comparable 2003 quarter.

Net income during the March 31, 2004 quarter increased as aresult of several factors. First, on a comparative basis, the provision forloan losses declined by $150 thousand between the quarters ended March 31, 2003and March 31, 2004. Secondly, noninterest income increased by a total of $288thousand as a result of increases in several components within this financialstatement line item. Services charges on deposit accounts increased $79thousand over the quarters presented, net fees for trust and brokerage servicesincreased $72 thousand, and mortgage banking income increased $65 thousand overthe same periods.  Although market interest rates continue to be well below historicalrates, during the first quarter of 2004, demand for new commitments related toresidential lending was substantially lower and pricing in the markets hasbecome more competitive, which resulted in reduced gains on sales totaling $210thousand for the quarter ended March 31, 2004 from $339 thousand for thequarter ended March 31, 2003. Also contributing to the Company's increased netincome for the quarter ended March 31, 2004 over the quarter ended March 31,2003 was the Company's emphasis on the management of operating costs, whichincreased only $236 thousand over the periods presented.

On a comparative basis, net interest income fully taxableequivalent increased by $15 thousand between the quarters ended March 31, 2004and March 31, 2003. The Company's net interest margin for the first quarter of2004 quarter declined to 4.85% compared with 5.26% during the quarter endedMarch 31, 2003. Management's goal is to maintain a reasonable balance relatingto its exposure to interest rate fluctuations and resulting earnings.  As such,the Company has balanced declining yields with asset growth.
 
 

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BALANCESHEET REVIEW 

SecuritiesThe primary objective of the Companyin its management of the investment portfolio is to maintain a portfolio ofhigh quality, highly liquid investments yielding competitive returns. Theseobjectives are achieved through the investment in the portfolios specificallyapproved by the Board of Directors of the Company. The Company is requiredunder federal regulations to maintain adequate liquidity to ensure safe andsound operations. Investment decisions are made by authorized officers of theCompany within policies established by the Company's Board of Directors. TheCompany maintains investment balances based on a continuing assessment of cashflows, the level of loan production, current interest rate risk strategies, andthe assessment of the potential future direction of market interest ratechanges. Investment securities may differ in terms of default risk, interestrisk, liquidity risk, and expected rate of return. Default risk is the riskthat an issuer will be unable to make interest payments or to repay theprincipal amount on schedule. United States Government obligations are regardedas free of default risk. The issues of most government agencies are backed bythe strength of the agency itself plus a strong implication that, in the eventof financial difficulty, the federal government would assist the agency.

AtMarch 31, 2004, the Company's investment securities available for saleportfolio totaled $106.4 million compared with $128.9 million at December 31,2003, a decrease of 17.5%. The composition of the investment portfolio at March31, 2004 was as follows: agencies 10%, municipalities 51%, and mortgage-backedsecurities and other securities 39%.  During the first three months of 2004,the portfolio balance was reduced supplying liquidityto the balance sheet allowing the repayment of federal funds outstanding. 

As was the case during the year endedDecember 31, 2003, investment securities previously held within the agency andtreasury portfolios have continued to be realigned into the municipalities andmortgage-backed security portfolios in order to meet interest-earning assetgrowth objectives, to provide additional interest income to offset lower loanoriginations, and to replace loan portfolio runoff. As a result of the recentinterest rate environment in which the Company has operated, prepayments in themortgage-backed securities portfolio have experienced an increasing trend. Thecontinued shift within the investment portfolio during the three-month periodended March 31, 2004 also reflected the Company's goal of having a portfolioconcentrated on total return as mortgage-backed and municipals are expected tooutperform on a total return basis in a rising rate environment.

Loan PortfolioGeneral.  Loans represent the mostsignificant component of interest-earning assets with average loans accountingfor 85.0% and 83.9% of average interest-earning assets for the three monthsended March 31, 2004 as compared with the year ended December 31, 2003. TheBank strives to maintain a diversified loan portfolio in an effort to spreadrisk and reduce exposure to economic downturns that may occur within differentsegments of the economy, geographic locations, or in particular industries. The Company's loan portfolioconsists principally of commercial loans, commercial real estate loans,consumer loans, sales finance loans, and mortgage loans. The Companyhas a diversified loan portfolio, and the borrowers' ability to repay theirloans is not dependent upon any specific economic segment. The Company'sbusiness is not dependent on any single customer or industry, or a fewcustomers or industries. Although the Company has the option to originate loansoutside of its home state, the Company originates the majority of itsloans in its primary market area of Upstate South Carolina. Certain risks areinherent within any loan portfolio.  For a discussion of such risks see theCompany's Annual Report on Form 10-K for the year ended December 31, 2003. 

At March31, 2004, the Company had total loans outstanding, including mortgage loansheld for sale, of $713.4 million, which equaled 88% of total deposits,including retail repurchase agreements and commercial paper, and 80% of totalassets.  Total loans outstanding at December 31, 2003 totaled $699.6 million.

 

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Mortgage loans held for sale were $6.4 million at March 31,2004 compared with $6.4 million at December 31, 2003.  The Bankmakes both fixed rate and adjustable rate mortgage loans with terms generallyranging from 10 to 30 years and generally retains servicing on loansoriginated. Real estate loan originations have been higher in recent years primarily dueto record low market interest rates resulting in increased refinancingactivity, although the Company has seen a decline in mortgage loan held forsale originations in recent months. 

The following table reflectsthe composition of the loan portfolio by loan type at March 31, 2004 and December31, 2003 (dollars in thousands).
 
At March 31, 2004

At December 31, 2003

Commercial  Business 

 $  90,418  

12.9
%
        $      87,950  

12.8
%
Commercial  Real Estate

         433,548  

    62.0

         420,470  

    61.4

Installment

          20,485  

      2.9

           22,169  

      3.2

Installment  Real Estate

           48,152  

      6.9

           47,560  

      6.9

Indirect 

           15,201  

      2.2

           15,644  

      2.3

Credit  Line

             2,043  

      0.3

             2,071  

      0.3

Prime  Access

           35,621  

      5.1

           33,014  

      4.8

Mortgage 

           44,785  

      6.4

           46,155  

      6.7

Bankcards

            9,572  

      1.4

             9,996  

      1.5

Business  Manager

             2,173  

      0.3

             2,200  

      0.3

Other

             1,148  

      0.2

             1,092  

      0.2

Gross  Loans

         703,146  

     100.6

         688,321  

     100.4

Allowance  for Loan Losses

           (7,692)

     -1.1

           (7,463)

     -1.1

Loans in  Process

            3,039  

      0.4

             4,086  

      0.6

Deferred  Loans Fees and  Costs

                814  

      0.1

                806  

      0.1

Loans, net

    $ 699,307  

 100.0
%
        $     685,750  

 100.0
%
As reflected in the table above,there were no significant fluctuations in the mix of the loan portfolio whencomparing balances at December 31, 2003 with those at March 31, 2004.  Management has continued its emphasis on loans secured by real estate duringthe first quarter of 2004 due to the reduced amount of inherent risk withinsuch loans compared with those secured by collateral other than real estate orloans that are unsecured. Additionally, as was the case during the year endedDecember 31, 2003, the Company has continued to see an increase in prime accessloans over the periods presented primarily resulting from the Company's noclosing costs promotional offering for such loans.

 

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At March 31, 2004 and December31, 2003, the Bank serviced mortgage loans for others with principal balancestotaling $272.1 million and $269.9 million, respectively.

CreditQuality.  A willingness to take credit risk is inherent in thedecision to grant credit. Prudent risk-taking requires a credit risk managementsystem based on sound policies and control processes that ensure compliancewith those policies. The Company believes it maintains a conservativephilosophy regarding its lending mix, and adherence to underwriting standardsis managed through a multi-layered credit approval process and review of loansapproved by lenders. Through loan review, reviews of exception reports, andongoing analysis of asset quality trends, compliance with loan policies ismanaged.

A loan grade classificationsystem is used for the Company's loan portfolio. Under this classificationsystem, loans graded "1" represent loans of superior quality. Loans graded "2"represent loans of high quality. Loans graded "3" represent loans that aresatisfactory. Loans graded "4" represent loans that are considered marginal.Problem assets are classified as "special mention," "substandard," "doubtful,"or "loss," depending on the presence of certain characteristics.

Assets determined to be problemassets are reserved at a higher percentage in accordance with the Company'sAllowance model than assets graded superior quality, high quality,satisfactory, or marginal, all for which general reserves are provided. Generalallowances represent loss allowances, which have been established to recognizethe inherent risks associated with lending activities, but which, unlikespecific allowances, have not been allocated to particular problem assets.

At December 31, 2003, there were $4.2 million of loansdesignated "special mention," $12.1 million of loans designated as"substandard," $1.1 million of loans designated as "doubtful," and $213thousand of loans designated as "loss." At March 31, 2004, there were $5.6million of loans designated "special mention," $13.0 million of loans designatedas "substandard," $1.0 million of loans designated as "doubtful," and $240thousand of loans designated as "loss." 

Overall, classified assetsincreased $2.3 million from December 31, 2003 to March 31, 2004. Materialincreases were seen in the commercial, financial, and agricultural portfolio aswell as the real estate portfolio offset slightly by a decline in the generalconsumer portfolio. The 2003 calendar year was a year of considerable economicuncertainty, nationally and in Upstate South Carolina, due in large part to thecontinued uncertainty following the terrorist attacks of September 11, 2001 andthe United States' presence in Iraq. Across the Company's market, unemploymentnumbers rose as businesses reacted to a weakened manufacturing sector.Management believes that, although the economy has begun to show signs ofimprovement, the residual impact of both the weakened manufacturing sector andthe increased job losses and personal bankruptcies of recent years continued toimpact the classified assets balances within both the commercial, financial,and agricultural portfolio and the real estate portfolio during the firstquarter of 2004. The slight decline in classified assets within the generalconsumer portfolio is contributed to the loan quality within the currentportfolio believed by management to contain higher-quality indirect loans thanthe portfolio has seen in recent years. 

Management periodically reviewsits loan portfolio and has, in the opinion of management, appropriately classifiedand established Allowances against all assets requiring classification underthe regulation. See Allowance for Loan Losses for additional discussionregarding established Allowances.

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The following table illustratestrends in problem assets and other asset quality indicators at the datesindicated (dollars in thousands). The quarter ended March 31, 2003 is includedas a comparison for 2004 non-annualized amounts.
  At   March 31, At December 31,   2004 2003 2003         Nonaccrual loans$3,236 3,578 3,828    Total nonperforming loans 3,236 3,578 3,828 Other real estate owned 3,239 2,548 2,170 Repossessed automobiles16698243   Total nonperforming assets$6,641 6,224 6,241         Loans past due 90 days and still accruing (1)$104 187 212         Total nonperforming loans as a percentage of          of loans (2) 0.46% 0.55 0.55         Total nonperforming assets as a percentage          of loans, other real estate owned, and repossessed         automobiles (2) 0.93 0.96 0.90         Allowance for loan losses as a          percentage of nonperforming loans 2.38x 1.89 1.95 
(1) Substantially all of these loans are credit card loans.(2) Calculated using loans, net of unearned,excluding mortgage loans held for sale.
 
Although the Company experienced adecline in nonperforming loans from December 31, 2003 to March 31, 2004, therewas relatively little change in the mix. At December 31, 2003, nonperforming loans were comprisedof 71.0% of loans secured by real estate, 17.7% of commercial and industrialloans, and 11.3% of loans to individuals for household, family, and otherpersonal expenditures. At March 31, 2004, nonperforming loans were comprised of65.0% of loans secured by real estate, 24.4% of commercial and industrial loans,and 10.6% of loans to individuals for household, family, and other personalexpenditures. Management believes the decreases of nonperforming loans over thetime periods noted are a reflection of management's more aggressive approach tomanaging loans.  Priorto recent times that have experienced increased bankruptcies and job losses,more flexibility was given for borrowers to make payments when they becamedelinquent. However, in response to the current economic times in which theCompany operates, the Company has applied more strict collection policies tosuch loans.  When the probability of future collectibility onnonaccrual loans declines from possible to probable, the Bank proceeds withmeasures to remedy the default, including commencing foreclosure action, ifnecessary.  As such, synonymous with the decrease in nonaccrual loans at March31, 2004 from December 31, 2003 is the increase in other real estate owned overthe same periods.  As the probability of future collectibility on nonaccrualloans declined from possible to probable during the first quarter of 2004, theBank proceeded with measures to remedy the default, through commencingforeclosure action. Real estate and personal property acquired by the Bank as aresult of repossession, foreclosure, or by deed in lieu of foreclosure isclassified within other assets on the consolidated balance sheet until suchtime that it is sold. See Other Assets for a complete discussion of thisportfolio. Of the $1.2 million added to the real estate acquired in thesettlement of loans portfolio during the first three months of 2004, $928thousand was concentrated within two commercial real estate properties.  Inaccordance with the Company's policy, appraisals were obtained on bothproperties at the time that they were transferred into the real estateportfolio.  Based on current information available to management at March 31,2004, it is believed that both properties were recorded at the lower of cost orestimated fair market value less cost to sell.  

Until sectors of the economy improve (employment, consumerspending, etc.), credit quality indicators will remain volatile. While currenteconomic data seems to be signaling improvement, the outlook remainsuncertain.  The Allowance model and the inputs required are discussed inAllowance for Loan Losses. Assessing the adequacy of the Allowance requiresconsiderable judgment. Management's judgments are based on numerous assumptionsabout current events, which management believes to be reasonable based on the informationavailable to them at the time such assumptions are made. Management believes,however, that, although the Company has seen an increase in both nonperformingand classified assets at March 31, 2004 from December 31, 2003, loss exposurein the Company's loan portfolio is identified, adequately reserved in a timelymanner, and closely monitored to ensure that changes are promptly addressed inits analysis of Allowance adequacy.  Accordingly, management believes theAllowance as of March 31, 2004 is adequate based on its assessment of probablelosses and available facts and circumstances then prevailing.  Additionally,management believes that there will always remain a core level of delinquentloans, nonperforming assets, and classified assets from normal lendingoperations.  To this end, long-term Bank goals include the management ofproblem assets.

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Allowance for Loan Losses The Allowance is maintained at alevel that management believes is sufficient to cover inherent losses in theloan portfolio at a specific point in time. Assessing the adequacy of theAllowance requires considerable judgment. The adequacy of the Allowance isanalyzed on a monthly basis using an internal analysis model. For purposes ofthis analysis, adequacy is defined as a level sufficient to absorb probablelosses in the portfolio. An Allowance model is used that takes into accountfactors including the composition of the loan portfolio including risk gradeclassifications (based on an internally developed grading system as describedin Loan Portfolio), historical asset quality trends including, but not limitedto, previous loss experience ratios, management's assessment of currenteconomic conditions, and reviews of specific high risk sectors of theportfolio. Loans are graded at inception and are reviewed on a periodic basisto ensure that assigned risk grades continue to be proper based on thedefinition of such classification. The value of underlying collateral is alsoconsidered during this analysis. The resulting monthly Allowance model and therelated conclusions are reviewed and approved by senior management. Theanalysis of Allowance adequacy includes consideration for loan impairment.

The fair value of mortgage loansheld for sale is based on prices for outstanding commitments to sell theseloans. Typically, the carrying amount approximates fair value due to theshort-term nature of these instruments. Likewise, such instruments are notincluded in the assumptions related to the Allowance model.

The methodology for assessingthe adequacy of the Allowance establishes both an allocated and unallocatedcomponent. The allocated component is based principally on current loan gradesand historical loss rates. The unallocated component estimates probable lossesin the portfolio that are not fully captured in the allocated Allowance. Theseanalyses include, but are not necessarily limited to, industry concentrations,model imprecision, and the estimated impact of current economic conditions onhistorical loss rates. On a continual basis, management monitors trends withinthe portfolio, both quantitative and qualitative, in order to assess thereasonableness of the unallocated component.

The Allowance is subject toexamination and adequacy testing by regulatory agencies. In addition, suchregulatory agencies could require Allowance adjustments based on informationavailable to them at the time of their examination.

The Allowance totaled $7.7million and $7.5 million, and $6.8 million, at March 31, 2004, December 31,2003 and March 31, 2003, respectively representing 1.09%, 1.08%, and 1.05% oftotal loans, less mortgage loans held for sale, for the same periods.

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The following table sets forththe activity in the Allowance at and for the dates indicated (dollars inthousands). The quarter ended March 31, 2003 is included as a comparison for2004 non-annualized amounts. Please note that losses and recoveries are chargedor credited to the Allowance at the time realized.
                                   
At and for the quarters   ended March 31, 
At and for the year   ended December 31,   2004 2003 2003        Allowance at beginning of period  7,463 6,402 6,402        Net charge-offs:              Loans charged-off  569 588 2,747       Less: loans recovered  48 57 208   521 531 2,539        Additions to reserves through provision  750 900 3,600        Allowance at end of period
$ 7,692 6,771 7,463        Average loans excluding mortgage              loans held for sale
$
697,478 630,452 659,683        Loans, net of unearned, excluding                  mortgage loans held for sale 
706,999 646,628 693,213        Net charge-offs as a % of average loans               excluding mortgage loans held for               sale (annualized, where applicable)  0.30% 0.34 0.38        Allowance as a % of loans, net of unearned,               excluding mortgage loans held for sale 1.09 1.05 1.08
Total net loan charge-offsdecreased slightly to $521 thousand for the three months ended March 31, 2004from $531 thousand for the same three month period of 2003. The decline incharge-offs over these periods was the result of declines in net charge offswithin the one to four family residential portfolio and the commercial andindustrial portfolio offset by increases in the nonresidential mortgageportfolio and the credit card and other consumer loan portfolios.  Annualizedquarter ended March 31, 2004 net charge-offs total $2.1 million compared withnet charge-offs for the year ended December 31, 2003 of $2.5 million.  Whencomparing these periods decreases were experienced within the commercial andindustrial and realestate loans secured by first liens offset by increases in other consumer net charge-offs(other than credit cards).  These fluctuations can be attributed to the lowinterest rates environment, which has led to increased consumer debt incurrenceand refinancing, and the recent indication that the economy is beginning torecover from recent uncertain times which in turn impacts job opportunitieswithin our communities making consumers better able to service their debt. 

Based on the current economicenvironment and other factors that impact the assessment of the Company'sallowance for loan losses as discussed above, management believes that theAllowance at March 31, 2004 was maintained at a level adequate to provide forestimated probable losses in the loan portfolio. See Loan Portfolio fordiscussions of factors impacting management's assessment of the allowance forloan losses. Although increases were experienced in both nonperforming assetsand classified assets from December 31, 2003 to March 31, 2004, management believes that lossexposure in the Company's loan portfolio is identified, adequately reserved ina timely manner, and closely monitored to ensure that changes are promptlyaddressed in its analysis of Allowance adequacy.  Accordingly, managementbelieves the Allowance at March 31, 2004 is adequate based on its assessment ofprobable losses and available facts and circumstances then prevailing.  Management'sjudgments regarding Allowance model inputs, which are believed to bereasonable, may or may not prove valid in the future. Thus, there can be noassurance that loan losses in future periods will not exceed the currentAllowance allocation or that future increases in the Allowance will not berequired, adversely impacting the operating results of the Company.

Other AssetsAt March31, 2004, other assets totaled $17.3 million compared with $16.1 million atDecember 31, 2003, an increase of 7.7%.

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At March31, 2004, major components of other assets included the Travelers Expressreserve totaling $1.9 million, net mortgage-servicing rights totaling $2.5million, pension plan assets totaling $2.9 million, other real estate ownedtotaling $3.2 million, and $4.1 million of intangible assets.  

At December31, 2003, major components of other assets included the Travelers Expressreserve totaling $1.9 million, net mortgage-servicing rights which totaled $2.6million, pension plan assets totaling $2.6 million, other real estate ownedtotaling $2.2 million, and $4.2 million of intangible assets.  

In August2002, the Bank established a reserve account with Travelers Express, its thirdparty official check vendor.  Prior to that time, Travelers Express paid checksand the Bank remitted the forwarded balance the following day, which resultedin payment of one day's interest to Travelers Express on the forwarded funds. The Company established this reserve account in order to eliminate the need forforwarded funds thereby eliminating interest payments to Travelers Express. 

See Note 2of Notes to Consolidated Financial Statements contained herein for discussionof the Company's mortgage-servicing rights asset.

See Note 5of Notes to Consolidated Financial Statements contained herein for discussionof the Company's noncontributory defined benefit pension plan.

Real estate acquired by the Bankas a result of repossession, foreclosure, or by deed in lieu of foreclosure isclassified within other assets on the consolidated balance sheet until suchtime that it is sold. When property is acquired, it is recorded at the lower ofcost or estimated fair market value less cost to sell at the date ofacquisition, with any resulting write downs being taken through the Allowance.Any subsequent write downs are taken through the consolidated statement ofincome. Costs relating to the development and improvement of such property arecapitalized, and costs relating to holding the property are charged to expense.Generally, any interest accrual on such loans would have ceased when the loanbecame 90 days delinquent as discussed in the Company's Annual Report on Form10-K for the year ended December 31, 2003.

The following table summarizes thechanges in the Bank's real estate acquired in settlement of loans portfolio, including thebalance at the beginning and end of each period, provision charged to income,and losses charged to the Allowance (in thousands). Thequarter ended March 31, 2003 is included as a comparison for 2004non-annualized amounts.
 At and for the quarters At and for the year   ended March 31, ended December 31,   2004 2003 2003 Balance, at beginning of period$2,170 2,468 2,468 Add: New real estate acquired in settlement of loans 1,155 169 1,595 Less: Sales of real estate acquired in settlement of loans 37 54 1,534 Less: Losses charged to the Allowance 29 35 191 Less: Provision charged to expense 20 -- 168 Balance, at end of period$3,239 2,548 2,170 
Due to the relatively low volume of properties within theother real estate owned portfolio, the foreclosure of new property or the saleof an existing property can cause the balance to fluctuate substantially on aquarterly basis.  Fluctuations of these balances relate primarily tocurrent economic conditions, which directly impact the borrower's ability toservice their debt. Of the $1.2 million added to the real estate acquired inthe settlement of loans portfolio during the first three months of 2004, $928thousand was concentrated within two commercial real estate properties.  In accordancewith the Company's policy, appraisals were obtained on both properties at thetime that they were transferred into the real estate portfolio.  Based oncurrent information available to management at March 31, 2004, it is believedthat both properties were recorded at the lower of cost or estimated fairmarket value less cost to sell.  

22

See Note 3of Notes to Consolidated Financial Statements contained herein for discussionof the Company's finite and infinite life intangible assets.

DepositsRetail deposits have traditionallybeen the primary source of funds for the Company and also provide a customerbase for the sale of additional financial products and services. The Companysets strategic targets for net growth in deposit accounts annually and hasdirected many efforts toward cross-selling thereby increasing the products perbanking relationship. Management believes that this is consistent with theCompany's vision to provide superior customer service. During the first threemonths of 2004, the Company continued to place emphasis on the growth of coredeposits.

The Company's traditional depositaccounts increased $7.1 million during the first three months of 2004.Management believes that conditions in fiscal 2004, 2003, and 2002 werefavorable for deposit growth as a result of factors such as the low returns oninvestments and mutual funds that may have increased traditional depositinflows. Such favorable conditions were greater in 2002 in the wake of the 2001terrorist attacks. As the economy started to show signs of improvement in 2003coupled with the low interest rates offered on many deposit accounts, investorsbegan to regain some confidence, which is reflected by the slowing growth inthe deposit portfolio when comparing with the growth during the first threemonths of 2004 to the growth during the first three months of 2003. TheCompany's average cost of these traditional deposits for the quarter endedMarch 31, 2004 was 1.50% compared with 1.85% for the quarter ended March 31,2003. The average cost of traditional deposits for the year ended December 31,2003 was 1.70%. Core deposits, which include checking accounts, money marketaccounts, and savings accounts, grew by $15.6 million during the first threemonths of 2004, or 3.7%, while higher costing time balances decreased by $8.5million, or 2.4%.  The decline in time balances is the result of increasedconsumer confidence, which often results in consumers reallocating investmentsto less conservative investment options. At March 31, 2004, total traditionaldeposits as a percentage of liabilities were 95.1% compared with 93.4% atDecember 31, 2003.  Contributing to this increase was the decline during thefirst three months of 2004 in the Company's federal funds purchased position.See Borrowings for further discussion of this decline.

The composition of the traditional deposit portfolio atMarch 31, 2004 follows: time accounts 44.6%, checking accounts 38.2%, moneymarket accounts 11.3%, and savings accounts 5.9%.  Although theCompany saw growth within the traditional deposit portfolio from December 31,2003 to March 31, 2004, there was relatively little change in the mix of thesedeposit accounts. 

BorrowingsThe Company employs additionalsources, in addition to traditional deposits, to supplement its supply oflendable funds and assist in meeting deposit withdrawal requirements. Retailrepurchase agreements, commercial paper, and federal funds purchased serve asthe Company's primary sources of such funds. The following table reflects the Company's borrowingscomposition for the periods indicated (in thousands).
  At March 31, At March 31, At December 31,   2004 2003 2003 Retail repurchase agreements$18,126 16,261 13,525 Commercial paper 16,339 16,965 16,170 Federal funds purchased -- -- 18,000    Total borrowings$34,465 33,226 47,695 
                                                 

Borrowings decreased $13.2 millionduring the first three months of 2004 primarily resulting from the Company'sreduction of its federal funds purchase position made possible by theliquidation of a portion of the Company's investment security portfolio.

23

 

Other LiabilitiesAt March31, 2004, other liabilities totaled $5.8 million compared with $6.6 million atDecember 31, 2003, a decline of 13.2%.

Thedecrease in other liabilities at March 31, 2004 compared with December 31, 2003of $875 thousand results from fluctuations in several accounts. Accrued income taxes, including bothcurrent and deferred income taxes, increased approximately $743 thousand atMarch 31, 2004 compared to December 31, 2003 based on the timing of taxpayments over the two periods. Taxes relating to the unrealized gain on investment securities availablefor sale increased approximately $303 thousand due to an increase in theunrealized gain on available for sale securities at March 31, 2004 fromDecember 31, 2003. Offsetting these increases was a decline in expenses accruedbut unpaid of $1.3 million between December 31, 2003 and March 31, 2004resulting primarily from the payment of officer bonuses that were accrued atDecember 31, 2003 and paid in January 2004. The majority of the remainingfluctuation in other liabilities between December 31, 2003 and March 31, 2004relates to decreases in mortgage lending related accounts, primarily themortgage-servicing clearing account, which decreased $804 thousand at March 31,2004 from December 31, 2003.  The volume of mortgage loans held for sale andthe timing of funding loans sold impact this account.  

Capital Resources andDividendsShareholders'equity totaled $74.7 million and $72.0 million at March 31, 2004 and December31, 2003, respectively.  Shareholders' equity as a percentage of total assetswas 8.4% at March 31, 2004 and 8.0% at December 31, 2003.  Duringthe first three months of 2004, shareholders' equity was impacted by theretention of earnings, by stock option activity, and by increases incomprehensive income. Cash dividends declared and paid during the first quarter2004 offset these increases. The consolidated statements of changes inshareholders' equity and comprehensive income contained herein provide detailof the changes in stockholders' equity components during the first three monthsof 2004.

During the first quarter of2004, the dividend payout ratio was 28.9% compared with a payout ratio of 26.2%during the same period of 2003. For the year ended December 31, 2003 thedividend payout ratio was 29.5%. Cash dividends per share for the first quarterof 2004 totaled $0.14, an increase of 16.7% over dividends per share for thesame quarter of 2003 of $0.12. The amount of dividends per share declared isdependent on the Company's earnings, financial condition, capital position, andsuch other factors, as the Board may deem relevant. The Company and the Bank are subjectto certain regulatory restrictions on the amount of dividends they arepermitted to pay as described in the Company's Annual Report on Form 10-K forthe year ended December 31, 2003.****The ability of theCompany to pay dividends depends primarily on the ability of the Bank to paydividends to Bancshares.

PalmettoBancshares Inc.'s book value per share was $11.92 at March 31, 2004 comparedwith $11.49 at December 31, 2003 and $11.02 at March 31, 2003.  

RegulatoryCapital Requirements The Companyand the Bank are subject to various regulatory capital requirementsadministered by the federal banking agencies.  Failure to meet minimum capitalrequirements can initiate certain mandatory actions by regulators that, ifundertaken, could have a material effect on the financial statements.  Undercapital adequacy guidelines and the regulatory framework for prompt correctiveaction, the Company and the Bank must meet specific capital guidelines thatinvolve quantitative measures of the Company's and the Bank's assets,liabilities, and certain off-balance sheet items as calculated under regulatoryaccounting practices.  The Company's and the Bank's capital amounts andclassifications are also subject to qualitative judgments by the regulatorsabout components, risk weightings, and other factors.

24

Quantitativemeasures established by regulation to ensure capital adequacy require theCompany and the Bank to maintain minimum amounts and ratios of total and Tier 1capital (as defined in the regulation) to risk-weighted assets (as defined inthe regulation) and to average assets.  At March 31, 2004, the Company and theBank were each categorized as "well capitalized" under the regulatory frameworkfor prompt corrective action.  To be categorized as "well capitalized," theCompany and the Bank must maintain minimum total risk-based, Tier 1 risk-basedand Tier 1 leverage ratios as set forth in the following table (dollars inthousands).  There have been no conditions or events of which management isaware since March 31, 2004 that would change the Company's or Bank'sclassification.   
        To be well        capitalized under     For capital  prompt corrective Actual adequacy purposesaction provisions amount ratio amount ratioamountratioAt March 31, 2004         *Total capital to risk-weighted assets*            Company$76,499 10.36% $59,062 8.00%N/AN/A   Bank 76,370 10.34     59,064 8.00   $ 73,831 10.00%            *Tier 1 capital to risk-weighted assets*            Company$68,807 9.32% $29,531 4.00%N/AN/A   Bank 68,678 9.30     29,532 4.00   $ 44,298   6.00%            *Tier 1 capital to average assets*              Company$68,807 7.77% $35,429 4.00%N/AN/A   Bank 68,678 7.75     35,439 4.00   $ 44,299   5.00%
For further discussion of the Bank'sand Bancshares' capital regulatory requirements, see Supervision andRegulations contained in Item 1 of the Company's Annual Report on Form 10-K forthe year ended December 31, 2003. 

Derivativesand Hedging Activities

Derivativetransactions may be used by the Company to better manage its interest ratesensitivity to reduce risks associated with its lending, deposit taking, andborrowing activities. The Company recognizes any derivatives as either assetsor liabilities on the consolidated balance sheets and reports these instrumentsat fair value with realized and unrealized gains and losses included in eitherearnings or in other comprehensive income, depending on the purpose for whichthe derivative is used and whether the derivative qualifies for hedgeaccounting in accordance with SFAS No. 133, "Accounting for DerivativeInstruments and Hedging Activities." 

Derivativeinstruments expose a Company to credit and market risk. Credit risk, the riskthat the counterparty to a derivative instrument will fail to perform, is equalto the extent of the fair value gain in a derivative. Credit risk is createdwhen the fair value of a derivative contract is positive since this generallyindicates that the counterparty owes the Company. When the fair value of thederivative contract is negative no credit risk exists since the Company wouldowe the counterparty. Credit risk in derivative instruments can be minimized byentering into transactions with high-quality counterparties as evaluated bymanagement. Market risk is the adverse impact on the value of a financialinstrument from a change in interest rates or implied volatility of interestrates. Establishing and monitoring limits as to the types and degree of riskthat may be undertaken can manage market risk associated with interest ratecontracts. Any market risk associated with derivatives used for interest raterisk management is fully incorporated into the Company's interest ratesensitivity analysis.

The onlyderivative activity in which the Company engages is commitments to originatefixed rate mortgage loans held for sale where the purchasing party undertakesthe interest rate lock risk.  Accordingly, no interest rate risk is involved insuch transactions. Commitments are generally recorded at their fair value atthe date of contract.  The fee collected for such commitments determines suchfair values.  

25

 

TheCompany's accounting policies related to derivative and hedging activities arediscussed in Note 1 of Notes to Consolidated Financial Statements containedwithin the Company's Annual Report on Form 10-K for the year ended December 31,2003.  

Off-BalanceSheet Arrangements

In the normal course ofbusiness, the Company engages in a variety of financial transactions that, inaccordance with generally accepted accounting principles, are not recorded inthe financial statements or are recorded in amounts that differ from thenotional amounts. These transactions involve elements of credit, interest rate,and liquidity risk. The Company uses such transactions for general corporatepurposes or for customer needs. Corporate purpose transactions are those usedto manage customers' requests for funding. 

The Company's off-balance sheet arrangements, whichprincipally include lending commitments, are described below. At March 31, 2004,the Company had no interests in non-consolidated special purpose entities. Neither Bancshares nor the Bank isinvolved in other off-balance sheet contractual relationships (other than thosediscussed herein), unconsolidated related entities that have off-balance sheetarrangements, or transactions that could result in liquidity needs.

The Bank makes contractual commitmentsto extend credit, which are legally binding agreements to lend money tocustomers at predetermined interest rates for a specific period of time. TheBank also provides standby letters of credit. The Company provides theselending commitments to customers in the normal course of business and appliesessentially the same credit policies and standards as it does in the lendingprocess when making these commitments.

For commercial customers, loancommitments generally take the form of revolving credit arrangements to financecustomers' working capital requirements. For retail customers, loan commitmentsare generally lines of credit secured by residential property. Unused creditcard lines are generally used for short-term borrowings.

Generally, unused loan commitments areat adjustable rates that fluctuate with the prime rate or are at fixed ratesthat approximate market rates.

The table set forth below illustratesthe Company's issued commitments to extend credit loan commitments and unusedcredit card lines at March 31, 2004 (in thousands).

Home equity loans
$
32,907

Credit cards
   
39,433

Commercial real estate development
   
50,491

Other unused lines of credit
   
32,552

Total unused commitment and unused  credit card lines
$
155,383   
 
Standby letters of credit
$
4,137
Outstanding commitments on mortgageloans not yet closed, the majority of which include interest rate lockcommitments, amounted to approximately $6.1 million at March 31, 2004. Thesewere principally single-family loan commitments. Commitments to extend creditare agreements to lend to borrowers as long as there is no violation of anycondition established by the commitment letter. Commitments generally havefixed expiration dates or other termination clauses. The majority of thecommitments will be funded within a 12-month period. The Company evaluates eachcustomer's creditworthiness on a case-by-case basis. The amount of collateralobtained, if deemed necessary by the Company upon extension of credit, is basedon management's credit evaluation of the borrower. Collateral held consists ofresidential properties. The Company originates and services mortgage loans. Allof the Company's loan sales within the first three months of 2004 were withoutprovision for recourse. 

26

Standby letters of credit represent anobligation of the Company to a third party contingent upon the failure of theCompany's customer to perform under the terms of an underlying contract withthe third party, or obligates the Company to guarantee or stand as surety forthe benefit of the third party. The underlying contract may entail eitherfinancial or nonfinancial obligations and may involve such things as thecustomer's delivery of merchandise, completion of a construction contract,release of a lien, or repayment of an obligation. Under the terms of a standbyletter of credit, generally, drafts will be drawn only when the underlyingevent fails to occur as intended. The Company can seek recovery of the amountspaid from the borrower. However, standby letters of credit are generally notcollateralized. In recent months the Company has reflected in its policyregarding such commitments that collateral is encouraged with exceptionsrequiring approvals. Commitments under standby letters of credit are usuallyfor one year or less. At March 31, 2004, the Company has recorded no liabilityfor the current carrying amount of the obligation to perform as a guarantor andno contingent liability is considered necessary, as the Company believes thelikelihood that it will have to perform under such contracts is not likely. Themaximum potential amount of undiscounted future payments related to standbyletters of credit at March 31, 2004 was $4.1 million. Past experience indicatesthat many of these standby letters of credit will expire unused. However,through its various sources of liquidity, the Company believes that it has thenecessary resources to meet these obligations should the need arise.Additionally, current fair values of such guarantees are deemed immaterial atMarch 31, 2004. 

The Company originates and servicesmortgage loans. Mortgage loans serviced for the benefit of others amounted to $272.1 million at March31, 2004.  Such loans totaled $269.9 million at December 31, 2003.

LiquidityThe term liquidity refers to theability of the Company to generate adequate amounts of cash to meet Companyneeds. Management determines the desired level of liquidity for the Company inconjunction with the Company's Asset-Liability Committee. The level ofliquidity is based on management's strategic direction for the Company,commitments to make loans, and the Committee's assessment of the Company'sability to generate funds.

Proper liquidity management iscrucial to ensure that the Company is able to take advantage of new businessopportunities as well as meet the demands of its customers. In this process,the Company focuses on assets and liabilities and on the manner in which theycombine to provide adequate liquidity to meet the Company's needs.

The Bank's liquidity is impactedby its ability to attract and retain deposit accounts, activity in and salesfrom its investment security and loan portfolios, alternative sources of funds,and current earnings. Competition for deposits is intense in the markets servedby the Company. However, the Company has been able to attract deposits asneeded through pricing adjustments, expansion of its geographic market area,providing quality customer service, and through the Bank's reputation among thecommunities it serves. The Company's deposit base is comprised of diversifiedcustomer deposits with no one deposit or type of customer accounting for asignificant portion. Therefore, withdrawals are not expected to fluctuatesignificantly from historical levels. The loan portfolio of the Bank is asource of liquidity through maturities and repayments by existing borrowers.Loan demand has been constant, and loan originations can be controlled throughpricing decisions. The investment securities portfolio is also an avenue forliquidity through scheduled maturities, sales of investment securities, andprepayment of principal on mortgage-backed securities. Approximately 38% of theinvestment securities portfolio was pledged to secure liabilities as of March31, 2004 as compared with 54% at December 31,2003. The Company feels the riskthat demand for the Company's products and services would reduce theavailability of cash from operations is not significant given the industry inwhich the Company operates. Although rapid technological change could presentrisks in this area, the Company feels as though it stays current on suchchanges. To review how these and other factors have impacted liquidity, seeconsolidated statements of cash flow contained herein.

27

Due to the fact that theCompany's sources of liquidity are often subject to various uncertaintiesbeyond its control, as a measure of protection, the Company has alternativefunding sources that have been arranged through federal funds lines atcorrespondent banks and through the Federal Reserve Discount Window. At March31, 2004, the Bank had unused short-term lines of credit totaling of $37million.

During fiscal 1999, the FederalHome Loan Bank (the "FHLB") instituted a general policy of limiting borrowingcapacity to a percent of assets regardless of the level of advances that couldbe supported by available collateral for such advances. This new policy servesto define an upper cap for FHLB advances of approximately $89 million at March31, 2004 based on its current approved cap. The FHLB requires that securities,qualifying single-family mortgage loans, and stock of the FHLB owned by theBank be pledged to secure any advances from the FHLB. The unused borrowingcapacity currently available from the FHLB ($89 million as discussed above)assumes that the Bank's $2.1 million investment in FHLB stock, as well ascertain securities and qualifying mortgages, would be pledged to secure anyfuture borrowings.

The liquidity ratio is anindication of a company's ability to meet its short-term funding obligations.The Company's policy is to maintaina liquidity ratio between 10% and 25%. At March 31, 2004, the Company'sliquidity ratio was 13%. Managementbelieves that the Company's liquidity sources during the first three months of2004 were adequate to meet its liquidity needs and to maintain the liquidityratio within policy guidelines.

Management's review at December31, 2003 (which analyzes the forward-looking twelve-month period) concludedthat its sources of liquidity appeared adequate to meet operational needs andto maintain the liquidity ratio within policy guidelines.  During the firstthree months of 2004, management was aware of no conditions or events thatwould change this conclusion.

Bancshares'cash needs include general operating expenses and the payment of dividends andinterest on borrowings.  Bancshares declared and paid cash dividends totaling$0.14 per share during the first three months of 2004.  Although there can beno guarantee that additional dividends will be paid in 2004, the Company plansto continue its quarterly dividend payments. 

 

28

EARNINGSREVIEW - COMPARISON OF THE RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED MARCH31, 2004 AND 2003

OverviewNet incomefor the three months ended March 31, 2004 totaled $3.0 million, up 4.4%compared with $2.9 million for the first quarter of 2003. Earnings per dilutedshare for first quarter 2004 were $0.48, a 6.7% increase from $0.45 per dilutedshare in the first quarter 2003. Earnings per basic share for the first quarter2004 were $0.48, a 4.3% increase from $0.46 per basic share for first quarter2003. 

Averagecommon shares outstanding on a diluted basis were 6,365,180 for first quarter2004, down 1.8% from 6,482,699 for first quarter 2003. Average common sharesoutstanding on a basic basis were 6,264,069 for first quarter 2004, down from6,326,698 for first quarter 2003. 

The Company's earnings increased during the first threemonths of 2004 as compared to the same period of 2003 due to several factors.Although the Company's net yield on interest-earning assets, fully taxequivalent, declined to 4.85% for the first quarter of 2004 from 5.26% for thefirst quarter of 2003, net interest income, fully tax equivalent, increasedslightly over the periods. Net interest income after the provision for loan losses for the threemonths ended March 31, 2004 and 2003 was $9.0 million and $8.9 million,respectively, an increase of 1.3%.  Noninterest income for the three monthsended March 31, 2004 totaled $3.7 million, up 8.4% compared with $3.4 millionfor first quarter 2003. Noninterest expense for the three months ended March31, 2004 increased $236 thousand from the three months ended March 31, 2003.

For the three months ended March31, 2004 the Company reported return on average equity of 16.44% and return onaverage assets of 1.37%.

NetInterest IncomeNet interest income is thedifference between gross interest and fees on interest-earning assets,primarily loans and investment securities, and interest paid on deposits andother interest-bearing liabilities and represents the largest component ofearnings for the Company. The net yield on interest-earning assets measures howeffectively a company manages the difference between the yield oninterest-earning assets and the rate paid on funds to support those assets.Fully tax-equivalent net interest income adjusts the yield for assets earningtax-exempt income to a comparable yield on a taxable basis. Balances ofinterest-earning assets and successful management of the net interest margindetermine the level of net interest income. Changes in interest rates earnedand paid on assets and liabilities, the rate of growth of the asset andliability base, the ratio of interest-earning assets to interest-bearingliabilities, and the management of interest rate sensitivity factor intochanges in net interest income.

The Company's net yield oninterest-earning assets may be affected by many factors. Competition fordeposit funds within the Company's markets range from many well-establishednational and regional banks and large credit unions to many smaller localbanks. The general level and direction of interest rates and national monetarypolicy also impact consumer deposit patterns and, thus, impact the Company'sability to utilize retail sources of funds. 

The following table presentsaverage balance sheets and a net interest income analysis on a tax-equivalentbasis for the quarters ended March 31 (dollars in thousands).

 

 

 

29
   
For the quarters ended March 31,
2004
2003
Average 
Income/ 
Yield/ 
Average 
Income/ 
Yield/ 
Balance
Expense
Rate
Balance
Expense
Rate
ASSETS
      Interest-earnings assets
Federal funds      sold
 $         5,838 
 $           15 
          1.03 
%
 $ 11,559 
          $      35 
          1.23 
%
Federal Home      Loan Bank stock and deposits
             2,606 
                  19 
          2.93 
             2,128 
                  23 
          4.38 
Nontaxable      investment securities (1) (3)
           54,757 
                751 
          5.52 
           34,357 
                569 
          6.72 
Taxable      investment securities (3)
           60,540 
                445 
          2.96 
           77,590 
                625 
          3.27 
Loans, net of      unearned (2)
          703,536 
           11,271 
          6.44 
          642,458 
           11,543 
          7.29 
Total      interest-earning assets
          827,277 
           12,501 
          6.08 
          768,092 
           12,795 
          6.76 
Noninterest-earning      assets
Cash and due      from banks
           27,514 
           29,564 
Allowance for      loan losses
            (7,493)
            (6,540)
Premises and      equipment, net
           21,876 
           19,779 
Accrued      interest
             3,827 
             4,109 
Other assets
           17,084 
           15,777 
Total      noninterest-earning assets
           62,808 
           62,689 
Total assets
 $890,085 
 $830,781 
LIABILITIES AND      SHAREHOLDERS' EQUITY
Liabilities       
      Interest-bearing liabilities
Demand deposits
 $263,526 
 $         225 
          0.34 
%
 $240,097 
 $        304 
          0.51 
%
Savings
           44,207 
                  31 
          0.28 
           39,277 
                  39 
          0.40 
Time
          349,993 
             2,201 
          2.53 
          331,553 
             2,440 
          2.98 
Total      interest-bearing deposits
          657,726 
             2,457 
          1.50 
          610,927 
             2,783 
          1.85 
Other      interest-bearing liabilities
           40,139 
                  65 
          0.65 
           34,073 
                  48 
          0.57 
Total      interest-bearing liabilities
          697,865 
             2,522 
          1.45 
          645,000 
             2,831 
          1.78 
Noninterest-bearing      liabilities
Noninterest-bearing      deposits
          112,755 
          107,944 
Other      noninterest-bearing liabilities
             5,528 
             8,640 
Total      noninterest-bearing liabilities
          118,283 
          116,584 
Total      liabilities
          816,148 
          761,584 
Shareholders'      equity
           73,937 
           69,197 
Total      liabilities and shareholders' equity
 $890,085 
 $830,781 
NET INTEREST      INCOME (FTE) (1) / NET YIELD ON
 $ 9,979 
          4.85 
%
 $9,964 
          5.26 
%
      INTEREST-EARNING ASSETS (FTE)
Tax-equivalent      adjustment (3)
 $         240 
 $188 
(1)
Yields on      nontaxable securities are stated on a fully taxable equivalent basis,      using the applicable effective tax rate of 
32% and 33% for      the quarters ended March 31, 2004 and 2003, respectively.  The      adjustments made to convert nontaxable
investments to      a fully taxable equivalent basis were $240 and $188 for the 2004 and 2003      periods, respectively. 
(2)
Nonaccrual      loans are included in average balances for yield computations.  The      effect of foregone interest income
as a result of      loans on nonaccrual was not considered in the above analysis.  All      loans and deposits are domestic.
(3)
The average      balances for investment securities include the unrealized gain or loss      recorded for available for sale securities.
 
 
30

Fully tax-equivalent netinterest income for the quarter ended March 31, 2004 increased $15 thousand, or0.2%, to $10.0 million from the quarter ended March 31, 2003.The fullytax-equivalent net yield on interest-earning assets decreased to 4.85% for thequarter ended March 31, 2004 from 5.26% for the quarter ended March 31, 2003.

The fact that the fullytax-equivalent net interest income remained relatively unchanged for thequarter ended March 31, 2004 compared with the quarter ended March 31, 2003 wasprincipally a result of a continuing decline in average yields oninterest-earning assets relative to the reduction in the average cost ofinterest-bearing liabilities. The Company's weighted average yield on interest-earningassets and weighted average cost of interest-bearing liabilities shown in theprevious table are derived by dividing interest income and expense by theweighted average balances of interest-earning assets or interest-bearingliabilities. As short-term market interest rates have declined, the Company'sinterest-sensitive liabilities repriced to an average cost of 1.45% during thefirst quarter of 2004 from an average cost of 1.78% during the first quarter of2003. Average yields on interest-earning assets declined to 6.08% from 6.76%over the same periods. Thedecline of the weighted average yield on interest-earning assets during first quarter 2004 over firstquarter 2003 was primarily the result of the decreasing yields of the loanportfolio, which was a direct result of the interest rate environment.  Thisdecline was only partially offset by repricing deposit accounts at lower rates.The weighted average yield of the loan portfolio decreased from 7.29% for firstquarter 2003 to 6.44% during the first quarter of 2004. 

Theunderlying factor for the changes in the yields and rates on interest-earningassets and interest-bearing liabilities has been the action of the FederalReserve Open Market Committee during the past 39 months. From January 2001through March 2004, the Federal Reserve cut interest rates 5.50%.  Variablerate loans typically reprice immediately following changes in interest rates bythe Federal Reserve.

Averageinterest-earning assets grew $59.2 million, or 7.7%, to $827.3 million forfirst quarter 2004 from $768.1 million for first quarter of 2003, primarilyfrom the growth of loans only partially offset by a decline in the Company'saverage federal funds sold. Average loans, including mortgage loans held forsale, were $703.5 million for first quarter 2004 compared with $642.5 millionfor first quarter 2003. Average interest-bearing traditional deposits increasedfrom $610.9 million for first quarter 2003 to $657.7 million for first quarter2004. Average other interest-bearing liabilities increased to $40.1 millionfrom $34.1 million over the same periods. Fluctuations in these averagebalances are typically simultaneous with fluctuations in financial statementbalances as noted in respective sections of this report.

Provisionfor Loan LossesThe provision for loan losses isa charge to earnings in a given period in order to maintain the allowance forloan losses at an adequate level defined by the Company's Allowance model. Theprovision for loan losses is adjusted each month to reflect loan growth and toallow for loan charge-offs, recoveries, and other factors that impactmanagement's assessment of the adequacy of the Allowance. Management'sobjective is to maintain the Allowance at an adequate level to cover probablelosses in the portfolio. Additions to the Allowance are based on management'sevaluation of the loan portfolio under current economic conditions, past loanloss experience, and such other factors, which, in management's judgment,deserve consideration in estimating loan losses. The provision for loan losseswas $750 thousand and $900 thousand for the three months ended March 31, 2004and 2003, respectively.  The Allowance at the same periods was $7.7 million and$6.8 million and represented 1.09% and 1.05% of loans less mortgage loans heldfor sale.

31

Net charge-offs during the firstthree months of 2004 totaled $521 thousand, or 0.30% of average net loans lessmortgage loans held for sale, compared with $531 thousand during the firstthree months of 2003, or 0.34% of average net loans less mortgage loans heldfor sale. The decline in charge-offs over the periods presented was the resultof declines experienced in net charge offs within the one to four familyresidential portfolio and the commercial and industrial portfolio offset byincreases in the nonresidential mortgage portfolio and the credit card andother consumer loan portfolios.  Management credits this decline to theirefforts over recent years toward reducing the number of lower-quality loans inthe loan portfolio.  As expected, as the lower quality loans seasoned, thelevel of resulting charge-offs initially increased. However, as a result ofmanagement's efforts, charge-offs within the loan portfolio have begun todecline, as noted above, since this time. Annualized net charge-offs at March31, 2004 total $2.1 million compared with net charge-offs for the year endedDecember 31, 2003 of $2.5 million.  Resulting from this recent credit qualityinitiative, management believes the loans in the current portfolio to behigher-quality loans, although a normal balance of inherent risk remains.  SeeBalance Sheet Review - Allowance for Loan Losses for additional informationregarding the Company's net charge-offs and discussion of such factors and their impact on the allowancefor loan losses and provision for loan losses.

In addition to decreased netcharge-offs impacting the current quarter's provision for loan losses decline,the decline in nonperforming loans also played a role in this decline.  Thesefactors were offset slightly by the impact of the growth within the loanportfolio over the periods as well as the increase experienced in real estateand personal property acquired in settlement of loans and classified assets. Management's analysis of these factors and the impact of these factors on theallowance for loan losses and the provision for loan losses for the quarterended March 31, 2004 resulted in a provision for loan losses for the firstquarter of 2004 of $750 thousand.  Although this provision reflects a $150thousand decline from that booked during the first quarter of 2003, theAllowance as a percentage of net loans less mortgage loans held for saleincreased from 1.05% at March 31, 2003 to 1.09% at March 31, 2004.

NoninterestIncome and ExpenseNoninterestincome for the three months ended March 31, 2004 totaled $3.7 million, up 8.4%compared with $3.4 million for first quarter 2003. Noninterest expense for thethree months ended March 31, 2004 increased $236 thousand from the three monthsended March 31, 2003.

Theincrease in noninterest income during the quarter ended March 31, 2004 over thequarter ended March 31, 2003 was the result of fluctuations in severalfinancial statement captions.  Service charges on deposit accounts increased$79 thousand, or 3.9%, over the periods noted, while net fees for trust andbrokerage services increased $72 thousand, or 12.0%.  Additionally, mortgagebanking income increased $65 thousand, or 65.0% during the first quarter 2004over the same quarter 2003.  

Service charges and fees ondeposit accounts comprise a significant component of other noninterest incomecomprising 56.0% of noninterest income during the first quarter of 2004. Thisincrease can be directly attributed to the growth of deposit accounts. Also contributingto the significance of this financial statement caption as a percentage ofnoninterest income was the introduction of an automatic overdraft productoffered to certain deposit customers beginning in 2001. In conjunction withthis product, a $29.00 fee is automatically charged to the customer's accounteach time an overdrawn check is written, up to a maximum overdraft amount of$500.00. Although management has seen an increase in charge-offs related tooverdrawn accounts, the fee income generated from this product more thancompensates for those charge-off increases. It is the Company's policy toautomatically charge-off such accounts when they become 65 days past due.Management views deposit fee income as a critical component of profitability. Periodicmonitoring of competitive fee schedules and examination of alternativeopportunities ensure that the Company realizes the maximum contribution toprofits from this area.

Net fees for trust and brokerageservices include fees earned through the Bank's subsidiary, Palmetto Capital,and the Bank's trust department. At March 31, 2004, assets under PalmettoCapital's management totaled $123.8 million as compared to the assets undermanagement at March 31, 2003 of $95.4 million. At March 31, 2004, assets underthe trust department's management totaled $264.7 million as compared to theassets under management at March 31, 2003 of $229.1 million. The increase infees earned correlates to the level of assets under management.

32

Mortgage banking income includes origination income,mortgage-servicing loss (net of the related amortization for themortgage-servicing rights for portfolio mortgage loans), losses and recoveriesrelated to the impairment of mortgage-servicing rights, and gains and losses onsales of portfolio mortgage loans. As management projected in itsAnnual Report on Form 10-K for the year ended December 31, 2003, due to theinterest rate environment, the Company has experienced lower residentialmortgage production than in recent years, resulting in reduced loan sale gains.Gains on sales of loans totaled $210 thousand for the three months ended March31, 2004, down $129 thousand from the three months ended March 31, 2003.Offsetting this decline in gain on sale of loans was a decline in the amortization and impairment ofmortgage-servicing rights.  Amortization of mortgage-servicing rights declined$181 thousand to $239 thousand for the three months ended March 31, 2004 overthe three months ended March 31, 2003.  An impairment of mortgage-servicingrights of $46 thousand was required for the three months ended March 31, 2003,while no impairment was recorded during the first three months of 2004.

In the more competitivefinancial services market of recent years, management has recognized the importanceof controlling noninterest expense to maintain and improve profitability.Management also recognizes that there are operational costs that continue toincrease as a result of the present operating climate for regulated financialinstitutions. The technical and operating environment for financialinstitutions continues to require a well-trained and motivated staff, superioroperating systems, and sophisticated marketing efforts. 

Theincrease within noninterest expense for the three months ended March 31, 2004from the three months ended March 31, 2003 was the result of fluctuations inseveral accounts with the majority of the change accumulated within onefinancial statement line item, salaries and other personnel expense, whichincreased $145 thousand over the periods noted.  The increase in salaries andother personnel expense for the three months ended March 31, 2004 compared withthe same period of 2003 is due to increased expenses related to medicalinsurance benefits provided to employees, life insurance premiums for executiveofficers, and the Company's defined benefit pension plan. Expenses related toemployee medical insurance benefits increased $42 thousand over the firstquarter of 2003 to $324 thousand.  Miscellaneous employee benefits, whichinclude life insurance premiums for executive officers, increased $52 thousandover the first quarter 2003 to $126 thousand. Additionally, expenses related tothe Company's noncontributory defined benefit pension plan increased $56thousand during the first quarter of 2004 over the same quarter of 2003.Full-time equivalent employees at March 31, 2003 totaled 366 compared with 372at March 31, 2004.

IncomeTaxesIncome taxexpense attributable to income from continuing operations totaled $1.4 millionfor both the first quarter 2004 and the first quarter 2003. The effectiveincome tax rate was 32% for first quarter 2004 and 33% for first quarter 2003. 

 

 

33
 
ACCOUNTING AND REPORTING MATTERS

Thefollowing is a summary of recent authoritative pronouncements that could impactthe accounting, reporting, and disclosure of financial information by theCompany.

In March 2004, the FASB formally proposedto require companies to recognize the fair value of stock options and otherstock-based compensation to employees for 2005 reporting periods, a policyconsistent with the related international standard released and withconvergence between the two sets of standards. The questions proposed at thispoint are how "share based payments" (to use the IASB term adopted by the FASB)should be valued and classified and the related implementation difficulties. The exposuredraft addresses only accounting for share-based awards to employees, includingemployee-stock-purchase-plans (ESPPs). Accounting for employee-stock-ownership-plantransactions (ESOPs) and awards to nonemployees will be taken up in a laterphase of the project. Comments on the exposure draftare due by June 30, 2004.

In April 2004, a new Consensusof the FASB's Emerging Issues Task Force ("EITF") was released that defines a"participating security" for purposes of determining earnings pershare and provides guidance on applying the two-class method for computingearnings per share. Some companies that issue participating securities willreport lower earnings per share under the new guidance than under previousrequirements.  The Consensus requires affected companies to retroactivelyrestate EPS amounts presented. The Company anticipates that this Consensuswill have no impact on the Company 's financial position or results ofoperations.

In April 2004, a new Consensusof the FASB's Emerging Issues Task Force was released which requires that companiescarrying debt and equity securities at amounts higher than the securities' fairvalues will have to use more detailed criteria to evaluate whether to record aloss and will have to disclose additional information about unrealized losses.The new guidance effectively codifies the provisions of SEC Staff AccountingBulletin No. 59 and creates a model that calls for many judgments andadditional evidence gathering. The newly required disclosures add to those theEITF prescribed in an earlier decision on the same issue. The impairmentaccounting guidance is effective for reporting periods beginning after June 15,2004, and the disclosure requirements for annual reporting periods ending afterJune 15, 2004. The Company will comply with the requirements of thistechnical literature for reporting periods and annual reporting periods endingafter June 15, 2004.  

Other accountingstandards that have been issued or proposed by the FASB or otherstandards-setting bodies that do not require adoption until a future date arenot expected to have a material impact on the financial position or the resultsof operations of the Company upon adoption.

 

34

**Item 3.  Quantitative and QualitativeDisclosures about Market Risk**

*Qualitative Disclosures*Market risk is the risk of lossfrom adverse changes in market prices and rates. The Company's market riskarises principally from interest rate risk inherent in its lending, deposit,borrowing, and investing activities that could potentially reduce net interestincome in future periods. This risk can also be reflected in diminished currentmarket values. Management actively monitors and manages its inherent rate riskexposure. Although the Company manages other risks, such as credit andliquidity risk, in the normal course of business, management considers interestrate risk to be its most significant market risk. This risk could potentiallyhave the largest material effect on the Company's financial condition andresults of operations. Other types of market risks, such as foreign currencyexchange rate risk and commodity price risk, do not arise in the normal courseof the Company's business activities.

Due to the fact that the netinterest income of any financial institution is vulnerable to fluctuations ininterest rates, the Company's management attempts to mitigate thisvulnerability through effective Asset-Liability Management. Such Asset-LiabilityManagement should maintain a balance between exposure to interest ratefluctuations and earnings. The Company defines Asset-Liability Management asthe process by which the Company changes the mix, maturity, and pricing ofassets and liabilities in an attempt to reduce a materially adverse impact onearnings resulting from the direction, frequency, and magnitude of change inmarket interest rates realizing that a sudden and / or substantial fluctuationin interest rates will impact the Company's earnings to the extent that theinterest rates on interest-earning assets and interest-bearing liabilities donot change at the same speed, to the same extent, or on the same basis. TheCompany's goal then is to minimize interest rate risk between interest-earningassets and interest-bearing liabilities at various maturities through itsAsset-Liability Management. Through Asset-Liability Management, the Companyseeks to achieve steady growth of net interest income with an acceptable amountof interest rate risk and sufficient liquidity.

Appropriate overall balancesheet parameters and guidelines are influenced by general economic and bankingconditions and by the Company's local market environment. Current parametersand guidelines of the Company 's Asset-Liability Committee include maintainingthe loan to deposit ratio in a range of 75% to 90%, using an increase ordecrease of 3% in the federal funds rate over a twelve month period as atrigger for minimizing exposure to interest rate shifts, maintaining a liquidityratio as defined by regulators in a range of 10% to 25%, and maintaining adependency ratio as defined by the regulators of 5% to 25%. It is noted thatthe projected negative impact on the Company's net interest income for thetwelve-month period is not to exceed 20% although management may have to takecorrective action during a period of sharply rising or falling interest rates.At March 31, 2004, the Company's loan to deposit ratio was 88%, which fallswithin the policy's permitted range of 75% to 90%, and the Company's liquidityratio was 13%, which falls in the policy's permitted range of 10% to 25%.

*Quantitative Disclosures*One tool the Company utilizes inassessing Asset-Liability Management is a simulation model used to analyzeinterest sensitivity gap (the difference between the amount of rate sensitiveassets maturing or repricing within a specific time period and the amount ofrate sensitive liabilities maturing or repricing within the same time period). The Company's rate sensitive assetsare those repricing within one year and those maturing within one year.  Ratesensitive liabilities include insured money market accounts, savings accounts,interest-bearing transaction accounts, time deposits and borrowings.  

35

 
 
The following table is a summary of the Company's one-yeargap (dollars in thousands):
 
                                                                                                                  

March 31, 2004
Interest-earning assets maturing orrepricing within one year   
$ 412,619    
         Interest-bearing liabilities maturing or repricingwithin one year                                    
341,819    
Cumulative gap
 $      70,800    
Gap as a percentage of total assets          
7.92 %
The aboveanalysis does not take i to account any prepayments on mortgages, consumer orother loans, or securities.  All maturities are stated in contractual terms.  The Company'sinterest-sensitive gap position, while not a complete measure of interestsensitivity, is reviewed periodically to provide insights related to the staticrepricing structure of assets and liabilities. The static gap position islimited because it does not take into account changes in interest rates orchanges in management's expectations or intentions. Based on the Company's March 31,2004 dynamic gap position in a one-year time period $412.6 million ininterest-earning assets will reprice and approximately $341.8 million ininterest-bearing liabilities will reprice. This current dynamic gap positionresults in a positive one-year gap position of $70.8 million, or 7.92% ofassets. 

A negative gap indicates that cumulative interest-sensitiveliabilities exceed cumulative interest-sensitive assets and suggests that netinterest income would decline if market interest rates increased. A positivegap suggests the reverse. This relationship is not always ensured due to therepricing attributes of both interest-sensitive assets and interest-sensitiveliabilities.

An important aspect of achievingsatisfactory net interest income is the composition and maturities ofrate-sensitive assets and liabilities. It must be understood, however, thatsuch an analysis is as of the date noted and does not reflect the dynamics ofthe market place. Therefore, management reviews simulated earnings statementson a monthly basis to more accurately anticipate sensitivity to changes ininterest rates. 

The earnings statements reviewedmonthly by management simulates the Company's consolidated balance sheets andconsolidated statements of income under several different rate scenarios over atwelve-month period. It reports a case in which interest rates remain flat andvariations that occur when rates gradually increase and decrease in incrementsof 100 basis points up to 300 basis points over the coming twelve-month period.Computation of the possible impact of hypothetical interest rate changes arebased on numerous assumptions, including relative levels of market interestrates and loan prepayments, and should not be relied upon as indicative ofactual results. Further, the computations do not contemplate any actions theCompany could undertake in response to changes in interest rates.

In conjunction with the annualbudgeting process for 2004, the Company projected a gradual increase in ratesrather than an immediate change. This projection was made because ratestypically change gradually over time rather than abruptly. 

According to the model as of the endof the first quarter 2004, if interest rates rise by 300 basis points over thecoming twelve month period, net interest income would be adversely affected byapproximately $3.3 million, or 8.1%. This model also shows that if interestrates rose by only 100 or 200 basis points over the coming twelve month period,net interest income would be adversely affected by approximately $808 thousand,or 2.0%, and $1.8 million, or 4.6%, respectively. The model also shows that ifinterest rates dropped 300 basis points, net interest income would be adverselyimpacted by approximately $4.1 million, or 10.1%. Similarly, if interest ratesdropped by only 100 or 200 basis points over the coming twelve month period,net interest income would be adversely impacted by approximately $1.3 million,or 3.1%, and $2.8 million, or 6.9%, respectively. The Asset-Liability Committeemeets weekly to address such interest-pricing issues. The projected negativeimpact on the Company's net interest income for the twelve-monthperiod does not exceed the 20% threshold prescribed by the Asset-LiabilityCommittee's policy as noted previously.

36

 

**Item 4.  Controls and Procedures**

*Evaluation of DisclosureControls and Procedures*An evaluation of the Company'sdisclosure controls and procedures (as defined in Rule 13a-15(e) and Rule15d-15(e) under the Securities Exchange Act of 1934) was carried out under thesupervision and with the participation of Bancshares' Chairman and ChiefExecutive Officer and the Bank's Chairman and Chief Executive Officer (ChiefAccounting Officer) and several other members of the Company's seniormanagement as of the end of the period covered by this Quarterly Report (the"Evaluation Date"). Bancshares' Chairman and Chief Executive Officer and theBank's Chairman and Chief Executive Officer (Chief Accounting Officer)concluded as of the Evaluation Date that the Company's disclosure controls andprocedures were effective in ensuring that the information required to bedisclosed by the Company in the reports it files or submits under theSecurities Exchange Act of 1934 is (i) accumulated and communicated to theCompany's management (including Bancshares' Chairman and Chief ExecutiveOfficer and the Bank's Chairman and Chief Executive Officer (Chief AccountingOfficer)) in a timely manner, and (ii) recorded, processed, summarized andreported within the time periods specified in the Securities and ExchangeCommission's rules and forms.

*Changes in InternalControls*During the first quarter of2004, the Company did not make any changes in its internal control overfinancial reporting or other factors that have materially affected, or arereasonably likely to materially affect, that control.

 

 

 

37
**PART II.  OTHERINFORMATION**

**Item 1. Legal Proceedings**

The Companyis currently subject to various legal proceedings and claims that have arisenin the ordinary course of its business. In the opinion of management based onconsultation with external legal counsel, any reasonably foreseeable outcome ofsuch current litigation would not materially affect the Company's consolidatedfinancial position or results of operations.

**Item 2.  Changes in  Securities, Use of Proceeds and Issuer Purchases of Equity Securities**

None

**Item 3.  Defaults Upon Senior Securities**

None

**Item 4.  Submission of Matters to a Vote of Securities Holders**

None

**Item 5. Other Information**

None

**Item 6. Exhibits and Reports on Form 8‐K**

*(a) Exhibits*

31.1      L. Leon Patterson'sCertification Pursuant to Section 302 of the Sarbanes-Oxley Act of 200231.2      Paul W. Stringer'sCertification Pursuant to Section 302 of the Sarbanes-Oxley Act of 200232         CertificationsPursuant to Section 906 of the Sarbanes-Oxley Act of 2002

*(b) Reports on Form 8-K*

On January 13, 2004, the Companyfiled a Form 8-K announcing the earnings release dated January 8, 2004, whichincluded selected financial data for the quarter ended December 31,2003 and forselect other previously reported periods.

 

 

 

38

SIGNATURES

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.

PALMETTO BANCSHARES, INC.

By:

/s/      L. LeonPatterson                           L. Leon Patterson Chairman and Chief ExecutiveOfficer Palmetto Bancshares, Inc.

/s/      Paul W. Stringer                                Paul W. Stringer Chairman and Chief ExecutiveOfficer (Chief Accounting Officer) The Palmetto Bank

Date:   May 10, 2004

 

 

 

 

 

 

 

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